James Tobin’s Finance and Social Welfare: 40 Years Ago

The key question is not whether finance has productive uses (of course it does), but whether the United States and other high-income economies are investing more resources in finance than can be justified by the social welfare benefits of such activities. Back in 1984, James Tobin thought the answer might be yes. Transcript of the lecture, “On the efficiency of the financial systemPublished in the July 1984 issue. Lloyds Bank Review. Tobin wrote:

The New York Times recently listed 46 corporate executives whose compensation in 1983 (salary and bonuses, excluding the realization of previously acquired stock options) exceeded $1 million. What surprised me was that 16 of these elite were executives in finance.’ It is no wonder, then, that finance is the most popular career path for my Yale undergraduates, and that 40 percent of the 1983 graduates of our School of Organization and Management ended up working in finance. … Every college educator knows that finance is a significant and growing sector of the nation’s most talented young men and women.

Tobin readily acknowledges the social functions of finance: facilitating transactions, channeling the economy’s pool of savings into productive investment in physical and human capital, pooling risk through insurance and hedging, providing incentives for the provision of information and analysis as part of the checks and balances on corporate governance, and providing assessments and guidance to existing firms and entrepreneurs. But as Tobin points out, the financial system only partially achieves some of these goals, and in some cases (a recent example is the Great Recession of 2007-09) its collapse contributes to the overall economic crisis.

I would like to point out the service [financial] The system is not cheap. A tremendous amount of activity takes place and considerable resources are invested in it. Let me remind you of some of the scale involved. Item: Finance and Insurance, a Commerce Department category, generates 4 1/2-5% of GNP, accounts for 5 1/2% of employee compensation, and accounts for about 5% of the employed labor force. They account for 7 1/2% of after-tax corporate profits. About 3% of personal consumption measured by the Commerce Department is financial services. This figure does not include the legal profession. That is about 1% of the economy, and a significant portion of the business is financial in nature.

Is it worth it? Tobin admits that he can only offer suspicions, not proven cases.

Any assessment of the effectiveness of our financial system must be a vague and uncertain verdict. In many ways, as I have tried to point out, the system serves us very well as individuals and as a society. But as I have tried to say, it does not deserve the conceit and self-praise of the industry itself or of the academic profession of economics and finance. …

I confess to a disturbing physiocratic suspicion, perhaps unbecoming of a scholar, that we are investing more and more of our resources, including our young generation, in financial activities that are far removed from the production of goods and services, activities that generate high private rewards relative to social productivity. I think that the enormous power of computers is being used in this ‘paper economy’, not to do the same transactions more economically, but to increase the quantity and variety of financial transactions. Perhaps this is why high technology has so far had disappointing results for overall productivity in the economy. I worry, as Keynes saw in his time, that the advantages of liquidity and transferability of financial instruments are being paid for by promoting short-sighted and inefficient n-th speculation.

Many of Tobin’s interests from 40 years ago have a very contemporary feel. In recent years, about a third of the total Harvard and yale Undergraduates (not just those in business schools, as Tobin said) go on to work in finance or consulting after graduation. The finance, insurance, and real estate sectors now account for about 7-8% of GDP, significantly more than they did 40 years ago.

Perhaps the most problematic is that finance is supposed to be a classic economy of scale industry. Imagine I have $10,000 invested in a mutual fund. Then I grow that to $20,000. Of course, it costs the fund manager money to set up my account and to notify me. But it is unlikely that managing $20,000 will cost twice as much as managing $10,000, and it is unlikely that managing $100,000 will cost ten times as much as managing $100,000. However, the revenues received in finance tend to track the total resources received over time. In other words, the industry that should be showing economies of scale does not seem to be doing so (see discussion here).

I have no more evidence of financial inefficiency than Tobin did 40 years ago. In fact, the fact that the same complaint was made 40 years ago suggests that the complaint itself is both real and exaggerated, given that all real-world markets are imperfect.

But being a party at the table when a financial transaction takes place may also give the financial sector an opportunity to cut a piece of the pie out of every transaction. After all, when you buy a show ticket, take out a mortgage, or have your credit card company charge you a fee for the transaction, there is no realistic choice to shop at that moment. When a company issues bonds, deals with private equity funds, buys back stock, or hedges currency risk, there are a limited number of financial parties willing to transact, and it may not seem realistic to offer such a financial transaction to the lowest bidder. It seems worthwhile to think about who sits in the middle of the transaction, what rules and competition put them there, and what reasons they have for participating in the transaction.

For a range of contemporary views on the question of whether finance is valuable, see “Symposium on Financial Sector Growth,” Spring 2013. Economic Outlook Journal (I was and am currently serving as editor-in-chief):